The Teflon-like US dollar continues to defy gravity. While off a bit from its recent October 2022 highs, the broad dollar indexes have resumed their sharp upward momentum over the course of this summer. As of this August, the dollar’s real effective exchange rate (calculated by the BIS) is up 12% from its May 2021 low. The narrower DXY index is up about 18% over the same period.
Anything I am about to say about the dollar needs to be taken with more than the usual grain of salt. Nearly three and a half years ago, I warned of the coming crash in the dollar. To say that call hasn’t exactly worked out is putting it mildly. The dollar went up instead of down and my cracked crystal ball shattered. I promised never again to utter another word about currencies.
Alas, I am tempted to break that promise for three reasons:
First, America is turning inward at precisely the time when it needs to draw on outward support to fund its gaping current account and saving deficits. Ed Luce’s recent piece in the Financial Times on “The Return of American Isolationism” drives this point home in the context of this week’s political upheaval in the US House of Representatives. Of course, this tendency has been building for years, turbocharged by the tariffs and sanctions associated with the rapidly escalating conflict with China. Luce makes a persuasive case that this week is different.
Second, the Fed is on the cusp of transforming its dollar-support role from a tailwind to a headwind. Of all the reasons I put forth in support of my earlier wrong way bet on the dollar crash scenario, the Fed call proved to be my ultimate undoing. I argued that the Fed would remain predisposed toward easing, digging in its heels on the “transitory Inflation” call that I strenuously argued was a serious error. Surprisingly, the Fed admitted its error and executed the most abrupt policy reversal on record. Never mind those current account and saving deficits—the Fed’s policy reversal was all that seemed to matter for the dollar. While the financial markets are currently fixated on the “higher for longer” aspect of the interest rate call, there can be little debate that Fed tightening is now in its final stages. At a minimum, that means a key tailwind for the dollar has been effectively neutralized.
Third, is the China factor. China has long been near the top of America’s foreign creditors. The official data points to some reduction in China’s holdings of US Treasuries since 2012. But as Brad Setser has recently pointed out in a very compelling piece, the shift is more statistical than real, as China has shifted its reserve holdings to offshore custodians such as Belgium’s Euroclear. By Setser’s reckoning, China’s total holdings of dollar-based assets—adding agencies and equities to his custodian-corrected measure of Treasuries—is $1.8 to $1.9 trillion, far in excess of that which can be inferred by US Treasury’s so-called TICs data which put Chinese holdings of Treasuries at $821 billion in mid-2023.
I cite this third factor as a risk to a weaker dollar because it suggests that China has so far done next to nothing to diversify its foreign exchange reserves out of dollar basis assets. As Washington now begins to restrict US inflows into Chinese assets—underscored by efforts of the House Select Committee to take aim on Blackrock and MSCI and reinforced by President Biden’s recent executive order aimed at outbound foreign direct investment—I think it is reasonable to expect China to respond in kind. That would be a dollar-negative retaliation.
So, there you have it—another compelling case against the dollar. Will the greenback finally lose is exorbitant privilege? I seem to remember a seemingly brilliant opinion piece in the FT making precisely that same point some three years ago. No one likes to break a promise. I am making that exception with great trepidation.
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